Worried About a Stock Market Crash? Prepare for the Bear Without Fear

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Here’s a reassuring statistic for you: In all but one stock market crash in the last 70 years, residential real estate went up in value, not down.

The notable exception, of course, was the Great Recession 10 years ago.

But just because that bear market remains top-of-mind for most of us, it doesn’t make it any less of a statistical anomaly. Historically, real estate is an excellent hedge against stock market collapses.

Let’s not get ahead of ourselves, though. Before we dive headfirst into bear markets and how real estate can help, I want to share a quick framework for matching short-term planning to your long-term goals and rolling with the motions of the markets.

Expansion Cycles

When I invest, I think in terms of expansion cycles and consolidation cycles.

My long-term, high-level financial strategy is twofold: grow my passive income and grow my net worth. Toward that end, I love rental properties, and I love equities (diversified in ETFs and mutual funds) because they further both goals.

An expansion cycle could be a quarter, or six months, even a year. But it should be a short time horizon, a short-term plan to advance your long-term goals.

In an expansion cycle, I aggressively buy up rental properties and invest in equities. I’ll leverage my rental purchases as much as possible. I max out my retirement accounts with equities.

That all sounds fine and dandy, right? Why ever stop investing, if these investments help me reach my long-term financial goals?

Consolidations Cycles

If you constantly run, run, run and keep throwing money around, you don’t give yourself a chance to learn from your mistakes.

Every investor needs to periodically pause and take stock. What’s working the way you intended? What hasn’t gone according to plan?

How comfortable are you with the amount of debt you’re carrying? And, of course, what’s going on in housing and equity markets?

In these pauses, investors can make defensive moves, such as paying down debt or stockpiling some cash. I call these phases consolidation cycles.

“Wait—Are You Saying I Should Try to Time the Market?”

No.

In the past, Scott Trench made a compelling case for why investors shouldn’t cringe on the sidelines simply because housing prices seem high. His logic holds true. Even when stocks or real estate is priced high by historical standards, it could continue rising for years to come. And when the next crash comes, who’s to say that the bottom will be lower than today’s prices?

Expert market analysts, whose entire educations and careers have been spent in this field, can’t predict how the market will move. Some tough love here: if they can’t predict market movements, you definitely can’t.

With that being said, market crashes can be a great time to buy. When everyone else pulls out, consider starting an expansion cycle.

But expansion and consolidation cycles are more about the rhythms of your personal finances and what’s happening in your life than they are about market conditions. When you start feeling overextended, it’s a good time to pull back and consolidate.

Related: The Irrefutable Advantage Real Estate Investors Have Over Stock Investors

If you have a major life change, such as beginning a new job, getting married, or having children, consider pausing to consolidate. Review your investments. Sell any assets you’re not enthusiastic about. Pay down debts. Beef up your cash reserves.

Rentals as a Hedge Against Stock Market Crashes

Robert Shiller, co-creator of the ubiquitous Case-Shiller Home Price Index, has a word or two to say on the subject. To most people’s surprise, he notes that historically “there is surprisingly little relation” between equity prices and residential real estate values.

In fact, if you look at annualized returns since 1953, home values have actually risen more during bear markets than bull markets!

That means that if you’re worried about a stock market crash, a logical place to put your money is in real estate. Rental properties in particular make a great hedge because rents tend to be relatively stable over time and rarely drop significantly.

And if you don’t like the look of how equity returns (over 10 percent) compare to the home price gains (under 5 percent) in that chart, don’t start sweating just yet. Those equity returns include dividend income, but the home price index only covers appreciation, not rental income.

Over time, returns from residential real estate are made up of roughly 50 percent appreciation, 50 percent rental income. In fact, a collaborative study between U.C. Davis, the University of Bonn, and Germany’s central bank found that rental properties were the best investment of the last 145 years. [1]

Leverage, Real Estate, and Good Debt

One of the great advantages of investing in real estate is the ability to leverage other people’s money to build your own net worth and passive income.

But an oft-overlooked perk of that leverage is that it opens a 100 percent safe, guaranteed place for you to put your money in a consolidation cycle: paying down your mortgages.

Imagine you borrow money at 6 percent to buy a rental property in one of your expansion cycles, and earn $300/month cash from that property. This is what Robert Kiyosaki famously calls “good debt”—debt that puts more money in your pocket each month, rather than costing you money.

No matter what comes down the pike, you can now earn a guaranteed 6 percent by paying down that debt. When you get spooked by what’s going on in the stock market, or in housing markets, you can still put your money to work for you, effectively earning a return. And when you pay off that rental property mortgage, you suddenly find yourself earning $800/month cash flow from the property, rather than $300.

In other words, the leverage on your real estate investments open up an entirely new set of defensive investments for you.

As you near retirement, it will grow ever more attractive to consolidate and play defense, rather than offense, with your investments.

Preparing for the Bear by Investing

Sound counterintuitive to prepare for a market crash by investing rather than selling?

That’s the beauty of rental properties. They hedge against inflation, they hedge against stock market crashes, and they even hedge against housing market crashes with the stability of rents and the ability to ride out stormy weather in the market while still earning positive cash flow.

Related: Should You Put Your Money into Stocks or Real Estate?

Try out this framework of thinking in expansion versus consolidation cycles. When you’re expanding and investing, you’ll know you’re furthering your long-term financial goals.

And when you pause for a consolidation cycle, you’ll know you still have plenty of options to advance those long-term goals, even without buying new investments.

Equities perform well over the long-term, as do rental properties. They just don’t always perform well at the same time—that’s why both are so useful for fitting short-term planning to your long-term goals.

Sources

[1] http://conference.nber.org/confer/2017/SI2017/EFGs17/Jorda_Knoll_Kuvshinov_Schularick_Taylor.pdf

How do you plan on investing your money over the next year? How do you decide where to put it? 

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.